A. Executory Contracts and Leases
1. Definition of Executory Contract
Recommended Principles:
• The Bankruptcy Code should define the term “executory contract” for purposes of section 365 as “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other,” provided that forbearance should not constitute performance. Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973). The contours of this definition are well developed under the case law and reflect an appropriate balance between the rights of a trustee to assume or reject contracts unilaterally under the Bankruptcy Code and the nondebtor’s obligations and rights in those circumstances.
Definition of Executory Contract: Background
Section 365(a) provides that a debtor in possession,410 “subject to the court’s approval, may assume
or reject any executory contract or unexpired lease of the debtor.”411 The Bankruptcy Code does
not define “executory contract,” and the legislative history of section 365 provides little guidance.412 Accordingly, the court on a case-by-case basis determines whether a particular contract is executory. Courts traditionally have used what is commonly referred to as the “Countryman” definition of
executory contracts.413 This test was developed by Professor Vern Countryman and defines an
408 11 U.S.C. § 365.
409 See, e.g., id. § 365(b) (requirements for assumption); id. § 365(c) (contracts not subject to assumption or assignment); id. § 365(f) (requirements for assignments).
410 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case.
See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model.
411 11 U.S.C. § 365(a).
412 H.R. Rep. No. 95-595, at 347 (1977) (“Though there is no precise definition of what contracts are executory, it generally includes contracts on which performance remains due to some extent on both sides.”).
413 See In re Baird, 567 F.3d 1207, 1211 (10th Cir. 2009); In re Columbia Gas Sys., Inc., 50 F.3d 233, 239 (3d Cir. 1995); In re Streets & Beard Farm P’ship, 882 F.2d 233, 235 (7th Cir. 1989); Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1045 (4th Cir. 1985); In re Select-A-Seat Corp., 625 F.2d 290, 292 (9th Cir. 1980).
executory contract for bankruptcy purposes as “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to
complete performance would constitute a material breach excusing the performance of the other.”414
Although widely used, courts have recognized limitations and potential inconsistencies in the application of the Countryman test.415 In addition, the test may not be a good fit for certain kinds of contracts.416
Given the noted flaws in the Countryman test, courts have developed alternative approaches to assess executoriness. For example, some courts use the “functional approach” to evaluate a debtor in possession’s request to assume or reject an executory contract. Under this approach, developed by Professor Jay Westbrook, there is no threshold standard of “executoriness” that the debtor in possession must meet to assume or reject the contract.417 Rather, the functional approach focuses on whether assumption or rejection would create a benefit for the bankruptcy estate and its creditors. The functional approach recognizes that courts often manipulate the threshold requirement of executoriness in order to produce the desired outcome.418 Several courts have adopted the functional
approach or used it in connection with the Countryman test.419
Another alternative approach is commonly referred to as the “exclusionary approach.” This approach
is a deviation from the Countryman test and was developed by Michael Andrew.420 The following
are the primary differences between the Countryman test and the exclusionary approach: (i) the concept of executoriness is irrelevant in the rejection context;421 and (ii) a contract is executory if each party has unperformed obligations, and if the debtor’s nonperformance eliminates its right
414 Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973).
415 See, e.g., In re Gen. Dev. Corp., 84 F.3d 1364, 1374 (11th Cir. 1996); In re RoomStore Inc., 473 B.R. 107, 111–12 (Bankr. E.D. Va. 2012).
416 Some courts have struggled with the application of the Countryman definition in the context of the following kinds of agreements: options and rights of first refusal; restrictive covenants (covenants not to compete; restrictive covenants on land); oil and gas agreements (e.g., the oil and gas leases themselves and variations thereof, like farmout agreements;, and related agreements, like surface use agreements and joint operating agreements); licenses, distributor agreements, and trademark agreements; warranties; rights of first refusal; employment contracts; and severance agreements; arbitration clauses; forum selection clauses; distributor agreements; trademark agreements; and indemnity clauses; and settlement agreements. See, e.g., Water Ski Mania Estates Homeowners Ass’n v. Hayes (In re Hayes), 2008 Bankr. LEXIS 4668, at *31–32 (B.A.P. 9th Cir. Mar. 31, 2008) (“[A] lthough restrictive covenants contain the characteristics of both a contract and an interest in land, the primary nature of such covenants is preservation of a land interest, not future duties in contract. Although there will almost always be some incidental continuing obligations under a restrictive covenant, those duties were not the kind of obligations Congress intended to impact in enacting § 365.”) (citation omitted); Frontier Energy, LLC v. Aurora Energy, Ltd. (In re Aurora Oil & Gas Corp.), 439 B.R. 674, 680 (Bankr. W.D. Mich. 2010) (“The court’s conclusion that the [oil and gas leases] qualify as ‘leases’ within the meaning of Section 365 makes it unnecessary to consider whether the [oil and gas leases] meet either the functional test or Countryman definition for executory contracts. Given the confusion in the case law, it is also improvident to opine on the question.”) (citations omitted); In re Bergt, 241 B.R. 17, 29–31 (Bankr. D. Alaska 1999) (discussing the application of the Countryman test in recent case law to options); Bronner v. Chenoweth-Massie, P’ship (In re Nat’l Fin. Realty Trust), 226 B.R. 586, 589 (Bankr. W.D. Ky. 1998) (“The contingent nature of the obligations arising from an option agreement make them quite distinguishable from the typical contract. This distinction has puzzled many courts, resulting in two distinct lines of cases. The first line of cases, while recognizing the contingent nature of the obligations arising under option agreements, and while also expressly acknowledging that they are unilateral contracts until exercised, have nevertheless engaged in what could be described as analytical gymnasts to arrive at a finding that they are nonetheless executory contracts.”) (citations omitted); Cohen v. Drexel Burnham Lambert Grp., Inc. (In re Drexel Burnham Lambert Grp., Inc.), 138 B.R. 687, 699 (Bankr. S.D.N.Y. 1992) (“Our readings persuade us that in each case, use of the Countryman test was neither necessary nor determinative. It was, rather, merely window dressing for results determined in the first instance by resort to another, sometimes unspecified criterion.”) (analyzing case law regarding application of Countryman test to employment agreements). See also infra note 424.
417 Jay L. Westbrook, A Functional Analysis of Executory Contracts, 74 Minn. L. Rev. 227, 282–85 (1989). 418 Id. at 287.
419 See, e.g., Route 21 Assoc. of Belleville, Inc., v. MHC, Inc., 486 B.R. 75 (S.D.N.Y. 2012); In re Majestic Capital, Ltd., 463 B.R. 289, 300 (Bankr. S.D.N.Y. 2012).
420 Michael T. Andrew, Executory Contracts in Bankruptcy: Understanding “Rejection,” 59 U. Colo. L. Rev. 845 (1988); Michael T. Andrew, Executory Contracts Revisited: A Reply to Professor Westbrook, 62 U. Colo. L. Rev. 1 (1991).
to the other party’s performance.422 Although courts have not adopted this approach, they have considered its factors in applying other tests.423
Definition of Executory Contract: Recommendations and Findings
The Commission conducted an in-depth review of the literature and case law on executoriness under the Bankruptcy Code. Some of the Commissioners noted their experience with litigation concerning the executoriness issue and the attendant uncertainty and expense. The focus of the executoriness
inquiry is whether each party has significant unperformed obligations under the contract.424 The
Commissioners discussed examples of contracts when this issue may be of particular concern, such as options, covenants not to compete, and oil and gas leases.425 Although executoriness is not necessarily a bright-line determination, the Commissioners generally agreed that courts resolve this issue fairly or parties are able to negotiate a resolution.
The Commission also considered the possibility of eliminating the concept of executoriness from
the Bankruptcy Code. Both the advisory committee and the 1997 NBRC endorsed this position.426
The Commissioners debated at length the potential utility to this approach. They discussed the meaningful benefits to refocusing contract disputes on the merits of the proposed assumption or rejection rather than extensive litigation on executoriness. The Commissioners supporting this approach emphasized the value to such a clean solution: with the distraction of executoriness off the table, parties could devote more attention on their rights, obligations, and remedies under the contract. Many Commissioners found the simplicity of this approach attractive.
Further deliberations about the elimination proposal revealed, however, the potential of unintended consequences of such a dramatic shift in a fundamental bankruptcy principle. The Commissioners
noted the common law origins of the executoriness requirement of section 365,427 and they also
422 Id. at 893.
423 See, e.g., In re Family Snacks, Inc., 257 B.R. 884, 905 (B.A.P. 8th Cir. 2001). 424 The Seventh Circuit Court of Appeals explained:
The Bankruptcy Code’s legislative history states that the term “executory contract” “generally includes contracts on which performance is due to some extent on both sides.’ A common definition, which this court has cited with approval, states that a contract is executory for bankruptcy purposes where “the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure to complete performance would be a material breach excusing the performance of the other.”
In re Crippin, 877 F.2d 594, 596 (7th Cir. 1989). See also Counties Contracting & Constr. Co. v. Constitution Life Ins. Co., 855
F.2d 1054, 1060 (3d Cir. 1988) (“The [Bankruptcy] Code does not define the term executory contract, however, courts have generally employed what has become known as the ‘Countryman’ definition of an executory contract, i.e., a contract under which the obligations of both the bankrupt and the other party remain so far unperformed that failure of either to complete performance would constitute a material breach excusing performance of the other.”) (citation omitted).
425 See, e.g., COR Route 5 Co., LLC v. Penn Traffic Co. (In re Penn Traffic Co.), 524 F.3d 373, 380 (2d Cir. 2008) (“While some courts have held that options contracts under which the optionee fully paid its price for the option to buy property before the debtor filed for bankruptcy are not executory (because no performance is due from the optionor unless the option is exercised), . . . others treat such contracts as executory.”) (citing conflicting case law) (citations omitted); Powell v. Anadarko E&P Co., L.P. (In re Powell), 482 B.R. 873, 877–78 (Bankr. M.D. Pa. 2012) (“Some courts have assumed that an oil and gas lease is an executory contract. Other courts have considered an oil and gas lease a transfer of an interest in real property and therefore not an executory contract.”) (citing conflicting case law) (citations omitted); In re Teligent, Inc., 268 B.R. 723, 730–31 (Bankr. S.D.N.Y. 2001) (“As a rule, Delaware law treats the covenant not to compete and the reciprocal promise to pay as material. As a result, the failure to make payment will discharge the obligation not to compete. . . . Where the covenant is given in connection with the sale of a business, it is even more likely to be deemed material. A covenant not to compete is often included in a contract to sell a business to protect the purchaser and allow him to enjoy the built-up good will.”).
426 See NBRC Report, supra note 37, at 21 (“Title 11 should be amended to delete all references to ‘executory’ in section 365 and related provisions, and ‘executoriness’ should be eliminated as a prerequisite to the trustee’s election to assume or breach a contract.”).
427 See In re Austin Dev. Co., 19 F.3d 1077, 1081 (5th Cir. 1994) (“Section 365 derives from § 70(b) of the former Bankruptcy Act, a provision that broadly codified the common law doctrine that allowed the trustee either to assume and perform the debtor’s
perceived value in maintaining some type of gating feature to vet those contracts that a debtor in possession could assume, assign, or reject in the chapter 11 case. Thus, the elimination of the executoriness concept could simply shift, rather than reduce, the amount of litigation or uncertainty in the first instance under section 365. Moreover, many Commissioners believed that the assumption or rejection decision was largely irrelevant to contracts that have already been fully performed by at least one of the parties.
The Commissioners also discussed the functional approach to determining executoriness, but most perceived the test to be unfair toward counterparties and too heavily weighted in favor of the interests of the debtor and the estate. The Commissioners acknowledged the potential value of allowing a debtor in possession to assume or reject any contract that would provide a benefit to the estate. As with the elimination proposal, however, the Commissioners were concerned about diminishing the rights of the nondebtor counterparties under the contracts. Subjecting any contract to section 365 primarily, if not solely, for the benefit of the estate imposed a greater burden on nondebtor parties than necessary to achieve a fair result for the estate in a chapter 11 case.
On balance, the Commission voted to adopt the Countryman test and to recommend its express incorporation into the Bankruptcy Code. The Commission found that, although imperfect, the Countryman test strikes an appropriate balance between the rights of debtors in possession and nondebtor counterparties to a contract. If the parties have material unperformed obligations, it is fair and reasonable to allow a debtor to choose to assume, assign, or reject such an agreement under section 365. The Commission also determined that many of the potentially challenging issues under the Countryman test have been resolved by the courts and that this case law is a valuable resource that would guide the implementation of the codified standard.